Ever since the 2018 liquidity crisis hit the primary market, secondaries transactions – the only liquidity solution then – have remained a hot topic in the private equity (PE) market.
Rushan Capital, a secondary investment veteran, processed over 50 secondary deals in 2020 alone, but ultimately only 2 of them landed safely. In this article, we explore some valuable lessons from Rushan Capital, focusing on 4 of the failed cases to illustrate the main difficulties in secondary trading.
1. Case One: Don’t Enter a Deal with an Offhand Counterparty
The first case originated from a fund manager (the GP) who, as an early-stage investor, enjoyed deep trust from the invested company. Thanks to this trust, the invested company informed the fund manager first of another institutional investor’s cash-out in an effort to find a buyer among existing investors to minimize troubles.
The GP came to Rushan Capital to sell shares of the invested project, claiming that they had obtained extra secondhand shares, with quota and the price all settled. Rushan Capital conducted price negotiation and due diligence, which both ended up well, but when sealing the deal, it turned out that the GP itself had not received extra shares yet and the seller had refused to liquidize its share.
The GP was to blame for 2 reasons: one was to be so confident in an oral agreement with the seller that it dismissed a written agreement; the other was to be ignorant of the real decision maker in the selling party. Thus, secondaries buyers can learn a lesson from this case: an experienced, professional and reliable counterparty is crucial.
2. Case Two: Appearances Are Deceiving
The second opportunity appeared good. Analysts from Rushan Capital were first impressed by its reliable source, a small and focused projects package with over 80% chance of getting listed. The sellers were currently under short-term liquidity pressure, so they even offered a discount on the market value.
However, as due diligence progressed, it turned out that the package was not that profitable – with a lower than 10% annual return rate – given the 4 years they had already existed. Such late-stage projects indeed were highly likely to go public, but the entering prices when they were still private were just too expensive and could even exceed their public market value. Eventually, Rushan Capital skipped this hot potato.
3. Case Three: More Isn’t Always Better
In this case, the secondary fund contained roughly 130 projects (from angel investment to series A round) worth nearly CNY1 billion ($154.6 million). In under 5 year’s active management, more than 110 projects successfully survived; some even reached dozens of times of floating Profit/Loss. Similarly, the seller wanted to withdraw their investment for liquidity.
5 years are still way too early to tell whether these 110 early-stage investments can make profits or not – not to mention that the due diligence for every single one of them would certainly be too pricy. After looking at so many secondary deals, Rushan Capital concludes that if the number of early-stage projects exceeds 20, the probable answer to the deal offer is “No”. The more projects in the secondary fund, the harder it will be for the transaction to close.
4. Case Four: Time Changes Everything
The final case here involves secondhand shares of a single-project, which should be deal-friendly itself. The seller and the fund manager were both familiar to Rushan Capital, and the selling party, needing liquidity, was happy to transfer fund share to Rushan Capital.
Everything was good, except the GP was then working on capital raising for a new fund and busy with various due diligence. Therefore, the GP failed to progress the share transfer procedures in a timely manner. About half a month later, some good signal for the project appeared, and the selling party instantly changed its mind. Strike while the iron is hot, as they say.
Some Final Words
The secondary transaction saves many sellers from liquidity pressure, but it is the buyer who takes over the risks. There may be tools like index, ratio, or market consensus that can help buyers to identify a profitable project, but the rest completely relies on past experience to tell if the deal is really that good. To guarantee a safe landing of secondary trading, trust and sincerity of both selling and buying parties are the integral elements.